[Another sample from The Nature of the Beast, from Chapter 11:  Economic Fire.  Another downloadable instalment will be available after Easter.]

Almost every institution involved in the financial system is, in the jargon, highly leveraged.  This is as true of old-fashioned banks with fractional reserves and mainstream banks with capital adequacy requirements as it is of shadow banks.  What does “highly leveraged” mean?  It means that you are betting a small amount on a large return.  If the return is positive, you make a handsome profit.  However if the return is negative you lose not only your stake but potentially everything you own.

If you invest $1000 in an enterprise that returns 15% a year later, you make $150.  However if you can persuade someone to lend you $9000 so you can invest $10,000, then the return will be $1500.  The return on your $1000 is magnified or leveraged to 150%.  However the risk is also magnified.  If the return is negative, -15%, in other words a loss, then you lose $150 on your $1000 investment and are left with only $850.  But if you invested the $10,000 then you lose $1500.  That means you lose all of your initial $1000 and you still owe your creditor $500.

It is time for some more parables, so we can figure out who is leveraged and who is not.  First is Honest Abe, the old-time money changer and safe-deposit manager, who issues paper receipts for coins people deposit with him, to be held in his vault.  Each receipt says it may be redeemed for the equivalent value in coins.    People would be able to use the receipts as money, standing in for the coins.  If the value of the coins in the vault is the same as or more than the value of the paper Abe has issued, then there should never be a problem.  Anyone who wants “real” money can exchange their paper notes for coins.  Abe’s business involves no leverage.

Next is Clever Clancy.  Clancy offers an arrangement with his depositors that he can loan some of their coins out, in return for a share of the profit he makes on the loans.  He offers them 2% interest.   His loans carry the condition that if his depositors require the coins then he can “call in” the loan, in other words require immediate repayment in coins.  He loans out ninety percent of the coins, keeping only ten percent as a reserve for people who need to redeem notes for coins.  This arrangement gives some protection to himself and his depositors, but less to his debtors.  If his depositors should want to redeem notes worth more than the coins he has on hand, he can call in some loans, retrieve the coins and pass them to his depositors.  Those whose loans are called in may suddenly have to sell things for less than their full value in order to raise the coins owed to Clancy.  If any debtors should be unable to repay their loans, then Clancy would lose and so would his depositors.  However the risk of default should not be great if he loans wisely.

Clancy’s arrangement introduces some risk for himself and his depositors, but he makes considerably more profit and his depositors also make modest profits.  So long as defaults are few, the main risk is to debtors, whose lives may be disrupted by a call-in.  Clancy’s business can be viewed as loan brokering.  However the loans are made with existing money (the coins), and so there is little risk of wider consequences.  Clancy’s business involves no leverage either.

Now we come to Slick Sam.  Sam starts out like Clancy, except he makes his loans with paper notes rather than coins.  As long as the loans total no more the 90% of the coins on deposit, his business should proceed in the same way as Clancy’s.  In fact it should run better, because there will be little chance of not being able to redeem notes for coins.  This is because the paper he has issued would amount to less than twice the coins he has on hand, whereas Abe’s deposit receipts would amount to ten times the coins he kept in reserve.

Realising this, Sam makes a crucial extension.  He starts loaning more than the value of deposits.  To do this he makes his receipts and his loans identical, so they both state simply that they may be redeemed for coins.  Then he makes loans worth ten times the value of the coins on deposit.  If he is careful, no-one need know he has loaned out more than he has.  His reasoning is the same as before, that only ten percent of people are likely to want to exchange their notes for coins at any given time.  In making this change, Sam has leveraged his deposits by a factor of ten.  He will make ten times more profit on the loans.  Unfortunately he has also magnified his risk.  Worse, he has created a systemic risk for his community.

Sam’s scheme increases the supply of money, because his notes can circulate as money.  This may for a time increase economic activity in the community, because his debtors will have spent their loan-money on whatever project they got the loan for.

However, if for any reason Sam’s depositors suspect that he might not be able to redeem their notes, there might be a rush to redeem notes and he will run out of coins.  He may attempt to call in loans, requiring they be repaid in coin.  This will create a shortage of coins as debtors scramble to sell things to raise the coins to repay their loans.  However it will also reduce confidence in the value of his paper notes.  If merchants know Sam is having trouble redeeming his notes, they may refuse to accept any more in payment for goods.  If that happens the notes may become worthless, and anyone holding them will lose.  The supply of money will suddenly decrease, because Sam’s notes cease to function as money, so the formerly booming economic activity will slow.

Unlike Clancy’s scheme, the consequences of the failure of Slick Sam’s scheme do not fall just on Sam and those dealing directly with him.  The consequences flow through the whole community.  Anyone holding his notes loses, but the whole community loses if the drop in the money supply impedes local economic activity.  In conventional terms, Slick Sam’s paper money first triggered a boom, then a recession.  This sequence of events happened many times through the eighteenth and nineteenth centuries.

Fractional reserve banking is also highly leveraged.  Banks may issue paper loans to a value ten times the value of their reserves (for a reserve requirement of ten percent).  This scheme differs from Slick Sam’s mainly in that the reserve fraction is not a secret.  Slick Sam practised fraud, because he let people believe he had coins equal in value to the notes he issued.  Given that most people probably do not realise banks loan more than the deposits they hold, by creating new money out of nothing, it is perhaps debatable whether the banking system is practising fraud.

Aside from that moral question, the practical result is that fractional reserve banking functions essentially in the way Slick Sam’s bank did, and it generates the same kind of risk, not only for itself but for the whole community.  If for any reason a lot of its loans should default, then it may not have enough reserves to cover the losses and it would become insolvent.  The money involved with the defaulting loans would vanish, the money supply would suddenly drop, and a recession or depression may be triggered.

Now modern banks do not practice simple fractional reserve banking any more, but they are still highly leveraged and therefore they generate at least as much risk.  Banks subject to capital adequacy requirements, like Australia’s, may have a broader buffer to call upon, but the concept is still that banks issue more loan-money than they could redeem in reserves, or gold or whatever.  If the US fractional reserve requirement applies only to individual clients and not to business clients, then their leverage will be even larger.

Finally, the shadow banking sector is overtly one of high leverage and high risk.  The financial instruments they deal in are all debt instruments, bets on the future.  They effectively multiply the money supply even more.  This is how private debt came to be 47 times greater than “base money” in 2007 (Figure 11.1b).

In technical terms, the high leveraging of the banking system sets up a powerful destabilising (positive) feedback.  Positive feedbacks are the ones that tend to magnify a trend.  Thus in good times the feedback tends to drive the money supply up, but when bad times come the same feedback tends to drive the money supply down.  Leveraged banking is a built-in generator of instability in our economies.  It is a major factor in causing recessions and depressions.